CHAPTER 15 MONETARY POLICY Monetary Policy Real GDP

CHAPTER 15 MONETARY POLICY Monetary Policy, Real GDP, and the Price Level

Monetary Policy, Real GDP, and the Price Level We have explained how the Fed can change the money supply Now we need to link up: � The money supply � The interest rate � Investment spending � Aggregate demand This lets us see how monetary policy affects the economy

Monetary Policy, Real GDP, and the Price Level A cause-effect chain: � Demand for money is comprised of two parts: Transaction Demand is directly related to GDP Asset demand is inversely related to interest rates, so total money demand is inversely related to interest rates.

MONETARY POLICY, REAL GDP, AND THE PRICE LEVEL Cause-Effect Chain • Money supply impacts interest rates • Interest rates affect investment • Investment is a component of AD • Equilibrium GDP is changed

MONETARY POLICY AND EQUILIBRIUM GDP Real rate of interest, i Sm 1 Sm 2 Sm 3 10 10 8 8 6 6 Dm 0 Quantity of money demanded and supplied Price level AS Amount of investment, i If the Money Supply Increases to Stimulate the Economy… §Interest Rate Decreases §Investment Increases §AD & GDP Increases with slight inflation P 3 P 2 P 1 0 Investment Demand AD 3(I=$25) AD 2(I=$20) §Increasing money supply continues the growth – AD 1(I=$15) but, watch Price Level. Real domestic output, GDP

Monetary Policy, Real GDP, and the Price Level Supply of money is assumed to be set by the Fed Interaction of supply and demand determines the market rate of interest (Figure 15 -2 a) Interest rate determines amount of investment business will be willing to make Investment demand is inversely related to interest rates (Figure 15 -2 b)

Chapter 15 Figure 15. 2(a)

Chapter 15 Figure 15. 2(b)

Monetary Policy, Real GDP, and the Price Level Effect of interest rate changes on level of investment is great because interest cost of large, long-term investment is a sizable part of investment cost. As investment rises or falls, equilibrium GDP rises or falls by a multiple amount. (Figure 152 c)

Chapter 15 Figure 15. 2(c)

Expansionary or Easy Money Policy The Fed takes steps to increase excess reserves, which lowers the interest rate and increases investment which, in turn, increases GDP by a multiple amount

Contractionary or Tight Money Policy Excess reserves fall, which raises interest rate, which decreases investment, which, in turn, decreases GDP by a multiple amount of the change in investment

Chapter 15 Table 15. 3